The FDR Framework is the backbone for a 21st century financial system. Under this framework, governments ensure that every market participant has access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to analyze this data because they are responsible for all gains and losses.

Monday, January 14, 2013

BoE power to change bank capital requirements and need for new banking model

The Bank of England published a draft statement explaining how its Financial Policy Committee would use its power to change bank capital requirements and improve the resilience of the UK economy.

A Wall Street Journal article highlighted how this statement implied that in using its power to change bank capital requirements the FPC would effectively be trading off growth for financial stability.

Underlying both the FPC's statement and the WSJ article is an assumption about how the financial system operates. Specifically, that loans are carried on bank balance sheets.

Regular readers know that your humble blogger agrees with the Bank of England's Andrew Haldane that the traditional banking model where loans are carried on the balance sheet is R.I.P.

The question is what will replace this traditional model and will the FPC's power to change bank capital requirements still be effective.

In an earlier post, I answered the question of what I think should replace the traditional banking model.

The financial crisis confirmed for all time that banks are bad holders of risk. This includes credit, interest rate and liquidity risk.

This should come as no surprise given past financial crises: Loans to less developed countries (credit), US Savings and Loans (interest rate) and the Great Depression (liquidity).

It was this recognition that banks were bad holders of risk that drove the creation of the 'originate to distribute' model. Under this business model, banks were suppose to transfer these risks to other financial market participants who were better able to hold these risks.

Clearly, the 'originate to distribute' model failed in the run-up to the Great Recession. The key question is why?

It failed along two correctable dimensions.

First, it failed because of a lack of transparency in the securities that were sold to transfer the risk. Structured finance securities from covered bonds to securitizations are brown paper bags where buyers are blindly betting on the value of the contents.

This is correctable by simply requiring observable event based reporting on all activities like payments or delinquencies involving the underlying collateral before the next business day. With this information, market participants can know what they are buying (which exerts market discipline on the pricing of the underlying collateral) and, on an ongoing basis, know what they own.

Second, it failed because of a lack of transparency into the banks themselves and the risks that they were taking on. Banks are, in Mr. Haldane's words, 'black boxes.' As such, they are not subject to market discipline as market participants cannot figure out how risky the banks are.

Instead, the financial system is dependent on regulators to both correctly assess and communicate the risk of the banks. The failure by regulators to do both correctly (and regulators are biased to not properly communicate the riskiness of the banks over concerns about "safety and soundness") results in the potential for financial contagion as market participants have too much exposure given the real risk of the banks.

This too is correctable by simply requiring ultra transparency and having the banks disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

The new business model should be the 'originate to distribute' model with transparency.

This business model restrains risk taking by banks while assuring that the economy has the access to credit it needs for growth. So the tradeoff that the Wall Street Journal article fears is eliminated.

But the question still remains as to whether the FPC's powers will be effective under this new business model.

Transparency under this new business model actually enhances the effectiveness of the FPC. It does this by allowing the FPC to harness the analytical ability of the market to identify potential problem areas in the financial system.

This allows the FPC to deploy the most important tool in its toolkit: the power to call attention to a problem.

At a minimum, by calling attention to a potential problem, the FPC is telling market participants that the risk is higher than market participants are currently anticipating. This warning should result in market participants adjusting their exposures to reflect this higher risk and in doing so mitigate the potential problem.

About this blog

A blog on all things about Wall Street, global finance and any attempt to regulate it. In short, the future of banking and the global financial system.

This blog will be used to discuss and debate issues not just for specialists, but for anyone who cares about creating good policies in these areas.

At the heart of this blog is the FDR Framework which uses 21st century information technology to combine a philosophy of disclosure with the practice of caveat emptor (buyer beware).

Under the FDR Framework, governments are responsible for ensuring that all market participants have access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to use this data because under caveat emptor they are responsible for all gains and losses on their investments; in short, Trust but Verify.

This blog uses the FDR Framework to explain the cause of the financial crisis and to evaluate financial reforms like the ABS Data Warehouse.